EMIR more Chuckle Brothers than Lehman Brothers!

I have recently,  through wrestling with the known unknowns of the Alternative Investment Fund Management Directive (AIFMD) revisited the European Market Infrastructure Regulations (EMIR) to ascertain how the two sets of regulations can be dovetailed where OTC contracts make up significant parts of Alternative Investment Funds (AIFs).

With my trusted tools of a large board and multi-coloured sticky notes I have made progress, well progress of sorts! I still come to a large ? at the end of the process.

While I was working for a Bank I attended several meetings trying to ascertain the impact of the first consultations seeking central clearing, transparency and collateral standards for the OTC derivative market places. As we worked through complex scenarios; parked controversial topics such as the need to build or buy new systems; clearly identify profit and loss (p&l) of each desk involved in a trade; and all of the divisional posturing and and denial that goes with such an exercise, I could only think about one thing, how do I explain this to a client?
I think it is therefore worth revisiting what went before the regulators started regulating, providing a tortured analogy and then concluding on the impact.

In the aftermath of the Lehman Brothers fall it became apparent that the Investment Banking dark arts had been very much in play in post-trade product management. Two plus two began life on the term sheets equaling four or near enough if you ignore amortizing p&l. Collateral would be posted and margin called within contractual parameters and established industry protocols. In the meantime all those otherwise redundant assets became inventory and indirect funding pools that could be re-hypothecated in the support of new contracts. All of a sudden two plus two became five, you could bet the p&l was being drip fed out of the price but it was far from certain that the assets were meeting the liabilities on the trading books and if they were, whether the internal trades between the exotic and security finance desks were booked correctly and stopping two plus two becoming three.

This may well be a jaundiced, generalised and simplistic view but for those of us involved in Investment Banking in the lead up to the Lehman's demise,whatever went on, the outcome is not a surprise. Structurers were constantly trying to identify efficiency to be competitive and maintain profit margins, in retrospect it is conceivable that the identified efficiency captured un-managed risks that so disastrously were realised to the detriment to all bank balance sheets. Whatever the truth and  the intent the G20 mobilised quickly and the trusted regulatory weapons of transparency and regulation were brought into play and draft regulations were agreed in principle as early as 2009. In Europe we eventually ended up with the European Market Infrastructure Regulations (EMIR) and now have an established time line albeit with need for clarification on material definitions.

So how do we make sense of these dark arts, simply call on Paul and Barry the "Chuckle Brothers". Even if you are unfamiliar with Paul and Barry it becomes very easy to establish their brand of pre-teen targeted situation comedy and apply it analogically to securities finance and collateralisation! Without further ado imagine the following scenario. Paul Chuckle wants a new battery put in his watch and asks his brother Barry to do it as he as a very good tool kit. Barry looks in the toolbox, only to find that the required screwdriver is missing. Paul remembers that he lent it to the Vicar and as he wants his watch fixed undertakes to get it back. The following dialogue then ensues:

Paul C: "Hello Vicar, I was wondering if I could have the screwdriver that I lent you back, please"
Vicar: Paul, forgive me but I have sinned, I lent it to Police Constable Grossman who needs it to fix his torch!" Paul C: "No problem, Vicar I'm off to the police station anyway so I'll ask him directly"

Now to save you from reading several pages of dialogue, I can summarise as follows, PC Grossman has lent the screwdriver to Terry Dogood the probation officer, who has in turn lent it to Tommy Tempted a rehabilitating petty thief. Tommy however lent the screwdriver to Sam Slippery the local wheeler dealer. Sam sold it to Mrs Pickle the Chuckle Brothers' landlady, for a pound.

While Paul is desperately following the screwdriver through the various transactions, Barry decides to ask Mrs Pickle if she has a screwdriver fit for purpose, which of course she has and Barry borrows it, and fixes Paul's watch. Paul returns with a pound having asked PC Grossman to intervene and force Sam Slippery to pass over his ill gotten gains. Paul gives Barry the pound, Barry gives Paul the screwdriver. Paul gives the screwdriver to Slippery Sam, who gives it to Tommy T, who passes it to Terry D, who of course gives it to PC Grossman who lets the Vicar have it back who then returns it to Paul who give it to Barry who now has the pound and the screwdriver, so he offers the pound to Mrs Pickle who accepts it under the circumstances.

There is a lot of the catch phrase "from me to you, to me , to you"......hilarious? Now of course this last transaction could have been undertaken by Paul giving Mrs Pickle a pound and the explanation, in this scenario he would have been fulfilling in conjunction with PC Grossman the role of a central clearer. What this situation does not take into account is the scenario where Mrs Pickle wants the screwdriver and doesn't accept the pound, and the cost of a replacement screwdriver to Barry is £1.20. In this scenario we let Barry and Paul argue who should pay the he extra 20p. Really we all know it should be Slippery Sam but he has run off to Malaga! The regulators have of course decided that nobody can run off to Malaga without leaving 20p, simple.

However rediculaous this anlaogy may seem some of the transactional flows I have anecdotally been made aware of are not far off, some I am reliably informed are as yet still unravelled, ie no one has decided who owes the 20p although someone has lost the it!.

This brings me to the ?.  How do I explain the requirements of EMIR to a client ? I'm not sure "it is collateralised" is going to help the Sales teams placate all those questions like, "what is the collateral, when is there a default, can collateral be re-hypothecated, is there margin in these transactions, can we have some of it off the price?

This is my point, the standard of transparency required for OTC transactions going forward, although laudable is significant. We do not expect a purchaser of a computer to understand how it works but what it does, with the safeguard that it will not kill you while it does it!  I believe that the complexities of the back office are irrelevant if the safe guards are inherent in the products and the enforcement robust. I'm not sure the latter details are anywhere near being pinned down as we still await in scope instruments and thresholds.

Back to the drawing board!

HRP April 2nd 2013 

What it says on the tin?

A short one today just to highlight a tortured irony rather than anything else! I would have thought that Lord Turner and Catherine Brown would not have been confused as Heads of the FSA. Lord Turner is probably welcoming the upcoming Twin Peaks just to clarify that his FSA will become the PRA and the FCA responsible for Prudential oversight of the big boys and conduct of everybody else in Financial services respectively. Its nice to see that the split is fairly accessible and each authority does what it says on the tin. As for Catherine Brown's FSA, I fear that food labelling may require far more work and the Foods Standard Agency may be struggling with consumer expectations more than than they thought they would have to.

At least any confusion between the two FSA's will be a thing of the past and there is no risk that Horse meat passed off as Beef will be compared to Endowments being passed off as Guaranteed returns, afterall we all want our products to do or at least be what they say on the tin,tray or packet whichever is applicable.

Huw Price February 2013

Unintended Consequences!

I admit it is easy to criticise the great and the good who are trying regulate the financial markets and the practitioners within them! see my last blog. I'm not certain that the route these bodies are taking is the most likely to get the desired results. The task to me is akin to Canute's self imposed challenge of turning back the tide but adds a couple more dimensions; firstly instead of setting a throne at the water's edge and commanding it to stop, the throne is set on a floating barge in the middle of the sea; secondly that sea is shark infested, a not too tortured analogy! The imposition of new rules and amendments to the old rules smacks of desperation to me. Whichever way you interpret it the legend of Canute is allegorical, either a self-effacing acknowledgement that Kings are mortal or a egotistical folly fuelled by the adoration of his subjects. The actions of the regulators are not allegorical they are real, imposed (admittedly after parsimonious consultation in some but not all areas) and real drivers of change. At the risk of the last sentence being interpreted as a positive it should be noted that change is not always benign it can be destructive or at least unintended and avoided at all costs just for it own sake.  Equally so, I would hope that the initial blame culture prevalent at the beginning of the crisis where governments blamed financial institutions,  regulators blamed distributors, journalists and consumers blamed everyone has been replaced by that most "illusive" of cultures, collective responsibility.

The following statements I would hope are not controversial and sum up the majority of the major issues that changes to the the regulatory environment are attempting to address.

1. The liabilities of major Financial institutions must be underwritten by assets with a surplus for sustained periods of stress.
2. Advice and remuneration for it must be transparent, fit for purpose and economically appropriate.
3. Retail consumers must be protected to a higher degree than Professionals and Institutions in their dealing in the financial markets.
4. Market practitioners must exhibit high standards of Professional integrity and accountability if they do not.
5. Consumers must be more educated in their understanding of the Financial markets and the relationship between risk and reward.

 I will be first to admit that the five statements are broad and the devil is in the detail, however if you could start again you would  not build the current models of Regulatory oversight that we see in the developed world. Stepping back my single biggest issue is that when you breakdown the value chain of most financial transactions you will identify a very real and material cost of regulation. Regulatory cost comes in various shapes and sizes whether it be Capital Adequacy ( the requirement to hold very liquid assets on balance sheet equal to a proportion of the liabilities of a business in the future, even if only to run down the business without client detriment; to the cost of armies of Compliance professionals tasked with keeping the business within the rules and the first line of protection for retail clients or the cost of reporting regularly to clients telling them how much they have made or lost in the experience. I am not advocating that the cost of regulation should be nil as this is clearly a nonsense, I am however concerned that the materiality of it is misunderstood. I work in a simple world where the measurement of the validity of a transaction or product can be assessed by the risk and reward profile inherent in the final return. Therefore if costs; manufacturing, distribution and regulatory are passed onto a client in the transaction they inevitably inhibit reward as a drag on return.

All to often the antidote to make the product or transaction more attractive will manifest itself as an increase in risk. Products and the underlying transactions in the whole are a provision of services, whether it be a combination of professional management aimed at growing or preserving wealth, matching an outcome to a need through advice or valuing, reporting and safekeeping. In the regulated world there is also an element of Fiduciary oversight and redress. As with any manufacturing industry the provision of such service comes at a cost which in turn covers the cost incurred by the service providers plus a realistic margin of profit. It is my contention that the regulatory cost and hurdles that exist before any product is launched creates a burden that influences the quality of the product and ultimately by extrapolation the choice of potential product available to the market.

Finally and at the risk of becoming a latter day Canute myself I am firmly becoming an advocate of a return to "Caveat Emptor", the principle of buyer beware! It is probably the wrong time to suggest that protection should be relaxed in Financial services given the relative excesses and failings exhibited over the last decade and frankly back to the late 80's when the regulatory framework as we know it began, however the very real cost of regulatory intervention will become prohibitive if it is not already for most consumers seeking choice. Leviathan funds may be the only choice for those seeking investment or savings products, since the sheer size does give the benefit of scale efficiencies accommodating costs at a relatively low ratio to  principal investment. All good you may think but only if the fund does what it says on the tin! As we know there is more than one FSA struggling with this issue and we certainly don't want retail investors seeking low volatility investment return and getting Horse meat instead!

HRP February 2013